Trusts and Income Tax: Who Pays?

Trusts are an incredibly useful estate planning tool, and they’re becoming ever more popular. As Trusts gain popularity, a question comes up more and more often: who pays the income tax on a Trust? It seems like a simple inquiry, but the answer can be hard to pin down.

So, who does pay the income tax on a Trust? Here is the answer, in a nutshell:

Grantor Trust

The first step in figuring out who is responsible for the income tax is to determine whether a Trust is a “grantor” Trust. The grantor is the person who created and funded the Trust, and a grantor Trust is one where the grantor has retained certain powers.

For instance, if you established a Trust and retained the power to substitute assets or to revoke the Trust, you have a grantor Trust. A grantor Trust is taxable to the grantor, whether or not any distributions were made from the Trust to the grantor during the tax year in question. In other words, if you have a grantor Trust, all the property in the Trust is treated as your property for income tax purposes. In fact, many grantor Trusts don’t even have their own tax identification number; instead, the income and expenses incurred by such Trusts are simply reported to the Internal Revenue Service under their grantor’s social security number.

Let’s look at an example:

James Smith creates the Smith Trust, a grantor Trust. The Trust has $30,000 in income for the year and it distributes $10,000 to Ellen, who is not a grantor. The entire $30,000 is included on James’ income tax return; Ellen does not include the distribution to her on her income tax return.

Non–Grantor Trust

Any Trust where the grantor did not retain specific powers is classified as a “non-grantor” Trust. A non-grantor Trust is treated as a separate tax entity from the person who created it, and taxation of this type of Trust depends on the distributions made by the Trust in any given tax year.

Let’s take a fresh look at the previous example:

If the Smith trust were a non-grantor Trust and it had $30,000, with a $10,000 distribution to Ellen, three things would happen. First, the Trust itself would file its own income tax return – Form 1041—to report its income for the year. Second, the Trust would issue a K-1 Form to Ellen, alerting her that she had $10,000 in income in the form of a Trust distribution. Third, Ellen would report the Trust distribution as income on her own personal income tax return – Form 1040.

If you are the creator or the beneficiary of a Trust, it is vital that you know the tax rules that apply. Otherwise, you could be failing to report income that should be taxed to you – or you could be reporting income on which someone else should be paying income taxes.